Understanding Adjusted Profits and how it can increase your business' value

I regularly cover how to improve the value of your business and why it’s important.

These improvements can become every line of your Profit and Loss:

• Increasing revenue (from better marketing)
• Reducing expenses (from better procurement and using management accounting to track all expenses)
• Increasing operational efficiency (by improving staff productivity)

Some are quick wins and low hanging fruit attainable over months. And some require upfront investment and many months or even several years to see the Return On Investment. The point is you, can go line-by-line and significantly change your bottom-line and business value – which may become your sale price.

 

In many small businesses, the taxable income declared on their tax returns doesn’t equal the true underlying profit of their business. This provides an opportunity to increase the potential sale value of their business today.

How?

You start with the taxable income (that comes straight from your tax return) and go through a process of working out ‘adjustments’ for things like personal expenses paid by the business to estimate the ‘true underlying profit’. Mostly this is higher than the taxable income, which obviously translates to a higher business value or potential sale price.

More detail coming, but the rub is as follows.

If you were aiming to sell your business at a typical small business multiple of 3X, then each $1 of legitimate addbacks found will get you an extra $3 in sale price.

Find $50K in addbacks and get $150K.

Let’s talk addbacks!

If you’re preparing to sell or wanting to better understand the value of your business, you’ll need some expert advice to get the adjustment process right.

To set-the-scene on what you would be doing and why, here is the background .

• When valuing or selling your business, you use tax returns (over three to five years) as the baseline measure of profitability. This becomes part of the formula for valuing the business.
• Tax Returns are skewed towards minimising taxable profit and, in turn, the tax you pay. This is par-for-the-course – most owners do it, so you aren’t alone.
• The taxable profit you declare often doesn’t represent the true underlying profit of the business.
• If you don’t understand what adjustments are possible with a credible way to convince a potential buyer, you are probably leaving money on the table.
• Note: adjustments can both increase and decrease your true underlying profit.

 

This is how I try to define and explain True Underlying Profit;

The ‘profit’ you could take out of the business as a dividend if you replaced yourself with a suitably capable employee to do what you currently do as the owner, and you authorised them to only spend what they needed to maintain the business as is.

The takeaway – if you don’t want to leave money on the table, you need to make a credible case for the maximum possible True Underlying Profit.

The rub – the concept of adjusting taxable profit is widely accepted. In theory it’s straightforward. In practice there is usually debate between sellers and buyers.

 

Greater academic minds than mine (and even a few AI bots!) might differ on ‘degrees of adjustment’, but it’s much better to be having some negotiation over the amount of an adjustment item than having nothing to negotiate at all.

Don’t try to fudge. Buyers (and their advisers) aren’t stupid. They understand the process and just want to get a better handle on future performance. It’s your important job to make the most credible case you can.

 

Here are some simple examples of common adjustments

To get a credible picture of Adjusted Profit, you need to think like an investor who owned 100% of the business but didn’t work in it, and your only objective was to maximise the dividend you got from the investment.

Then you go through the tax returns line-by-line. And you keep asking yourself questions like;

1. Is the level of each expense sufficient to keep the business humming?
2. What are one-off costs?
3. Are there any ‘discretionary’ expense items?

 

Might sound daunting, but it’s not. There’s a well-oiled process and I do it every day with business owners. Mostly we find value they weren’t aware of.

If you want help with adjusted profits, check out my Value & Sellability Diagnostic or contact me.

 

However, it's important to note there are definitely pitfalls to avoid.

1.   Buyers (and their advisers) will find overstated adjustments in due diligence.

2. No matter how rational you make the case for an ‘addback’ and how much detail you provide a potential buyer in support, it can raise questions about the ‘addback’ in question and your overall financials. This can reduce the enthusiasm of some buyers.

 

It’s true that ‘cleaner’ (i.e. no adjustments at all) business financials make your business easier to sell. Not to mention it reduces any anxiety over compliance with ATO guidelines.

It makes sense, and I advise owners actively preparing to sell to ‘clean up their business finances’. In my experience though, it’s only a small percentage of SMEs that go to market to sell with pure, adjustment free finances. 

The reality remains there are many owners (supported by their trusted Accountant) who have and continue to run their businesses in a way that mix some discretionary and personal expenses within their business.

It can take years to sell, and many viable businesses won’t. So, while those owners remain at the helm, I understand why they might continue to take advantage of the aforementioned opportunity to run some personal expenses through the business.

For owners actively preparing to sell or those who want to get a more accurate understanding of what their business is worth, the message is straightforward.

Understand your numbers line-by-line.

All the best, Michael